An Expert Focus article on Waterbriefing explores whether the tide of investor appeal will rise or fall as the water industry takes on direct procurement.

Until now, UK water companies have themselves raised the finance needed for large, new infrastructure projects. But that’s changing as Ofwat opens up the sector to promote more competition through direct procurement, with water companies going to the market for project finance. So what will this mean to companies and investors?

In its ‘Water 2020’ report Ofwat states:

“Our shared vision for the water sector in England and Wales is one where customers and wider society have trust and confidence in vital public water and wastewater services.”

"Delivering this vision relies on everyone in the sector working together, listening to customers and tackling long-term challenges. We are making changes to the way we regulate in future to play our part in building trust in water. [And we] will build on the successes of our previous price review and go further, for the benefit of customers, the environment and wider society.”

So how will this bold vision from Ofwat unfold in practice?

Direct procurement - an exciting opportunity

Guy Ledger, business development director at Atkins and previously director of water operations at the consultancy, believes a revolution is already in progress. He said:

“It’s already started. In a few short weeks competition in the water retail sector will go live, giving some 25,000 businesses across the UK the option to switch suppliers and consolidate their water and wastewater services.”

“And now on the table is the introduction of direct procurement. It’s an exciting opportunity. Essentially for very large projects, with a value of £100 million or more, water companies can go to the marketplace not just for design and construction – as they’ve always done – but also for project financing; opening up the opportunity for new consortia to deliver the industry’s biggest and most exciting projects.”

“Building large, new infrastructure is a costly and risky business, and Ofwat is more than aware that eventually the customer foots the bill. Raising project-specific finance from new investors and consortia could change the dynamics of the market, leading to commercial innovation and ultimately better value for end users.”

This model is already being used in the £4.2 billion Thames Tideway ‘super-sewer’, London’s second biggest infrastructure project after Crossrail. The 25-kilometre sewer will prevent an average 20 million tonnes of untreated sewage being discharged into the River Thames each year and is being funded through a combination of increases in Thames Water customers’ bills together with a £2.8 billion investment from Tideway, whose investors have invested £1.2 billion of equity.

So will very large infrastructure projects actually appeal to investors?

There are other projects, too, albeit somewhat smaller in scale, that Ofwat cites as having had the potential to be funded by this new direct procurement model. These include the Severn Trent Birmingham Resilience project to construct a new water supply pipeline from its reservoirs in Wales into the east side of Birmingham – at a cost of around £260 million – and the Wessex Water project to create an integrated supply grid at a cost of more than £100 million. So, the crucial question is, will very large infrastructure projects of this type, such as a large treatment works, and pipelines being laid over long distances, actually appeal to investors?

Tideway is certainly being seen across the industry as a litmus test for what good could look like but that was a mega-project with a £4.2 billion price tag.

Incumbent water companies may be ... required by the regulator to put some capital projects out to tender

Peter Hall, projects lawyer at global law firm Norton Rose Fulbright in London where he leads nuclear energy and water groups said:

“To my mind this approach is better suited to the larger projects; those well in excess of £100 million. In that scenario, I think what will happen is that incumbent water companies are going to be encouraged, or maybe even required, by the regulator, to put out to tender some of their capital projects.”

In some respects, water companies are doing this already, by financing projects through the weighted average cost of capital (WACC), now regarded as the Holy Grail of financial modelling in the sector and a key share price driver and determinant of utility charges. In other words, the cost of debt plus equity as determined by the regulator.

Peter Hall added:

“But it seems to me that the reason Ofwat is promoting direct procurement is that there’s a perception that the market could set an equivalent cost of finance that is below that set by the regulator in its five yearly reviews. If we look at the Thames Tideway Tunnel, the type of equity that was targeted was ‘institutional’ pension-fund type equity.”

“This kind of investment model is one that seeks less risk, and a steadier return, with funders taking a much longer-term view of the asset.”

Companies could find themselves delivering new assets....effectively treated as third party assets

“By going down the route of direct procurement, there is an opportunity to look beyond the traditional five year horizon and look at cost of capital and revenue requirements over a much longer time frame. This kind of longevity, when combined with an appropriate risk profile, is likely to attract the longer term aspirations of ‘institutional’ equity funds.”

But such an approach should not exclude the possibility of other financial investment models surfacing; for example, a 'project' bond market, as a means to raise finance, could emerge. At present, companies build their new assets, and those new assets add to the company’s overall Regulated Capital Value and as the Regulated Capital Value increases, so the company revenue increases as it keeps adding new assets.

However, in a post direct procurement world and with the regulator now looking increasingly at Totex rather than Capex, the incentives to focus on capital expenditure are diminishing and companies may find themselves delivering new assets, financed, built, and effectively treated as third party assets.

Guy Ledger added:

“We don’t know the details yet, but arguably it means that water companies may not get the benefit of the additional regulatory capital value, and so risk not getting a subsequent return on those assets. So, whilst direct procurement could be attractive to an investment consortium, it may not be so attractive to the company. It’s possible this may have an adverse knock-on effect for shareholders, by creating uncertainty for regular investors. This is something that’s untested at the moment – so there are a lot of unknowns as things stand.”

Who takes a broader view of the best direction for large-scale projects in the national interest?

Roddy Adams, managing director within Atkins Acuity who leads on finance and economics activity in an advisory capacity to help get Atkins’ global clients’ large-scale infrastructure projects underway commented:

“From my perspective, for developments in the water industry in the UK, the bit that’s missing in all this is who is sitting above the water companies and the regulator? Who’s taking a broader view of what’s the best direction for large-scale projects that are in the national interest?”

Adams and his team have seen many projects that, due to their sheer scale and size, transcend company, or geographical, boundaries. So for the UK how are things going to change within the industry to facilitate a real step-change, and make meaningful large-scale projects happen?

He said:

“We’ve seen worthwhile projects that are initially deemed “too difficult” getting delivered because they are front and centre in the national interest; because they become essential. With Tideway the UK Government pushed this along because otherwise there would have been fines under EU regulations.”

“Introducing a mechanism that forces larger projects through to direct procurement is something we’d really like to see. If there are big reservoir projects needed, that cut across water companies’ boundaries, direct procurement would prove a good model, and plenty of lenders are prepared to take project finance risk. I think there’s a market there ready to finance – but we also need the mechanism to push them through.”

Looking at projects in this way, from the investor’s angle, could indeed open up new and attractive propositions, and we may even see a raft of inter-sector investment opportunities come to the forefront within a few years.

Imagine the opportunities. Not just sideways investment into housing, but also other possible regulatory changes that could be prompted by a success in the take-up of the direct procurement model, and this longer view of investment. Could it only be a matter of time before we see new entrants or outside investors exploit the deregulation of the sludge market or abstraction market within the water industry too?

There are early signs of significant change ahead and market participants need to be planning for these changes now. Returning to those words from Ofwat:

“Delivering this vision relies on everyone in the sector working together… and tackling long-term challenges.”